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Transcript of © 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 6: Using Demand and Supply:...
© 2006 McGraw-Hill Ryerson Limited. All rights reserved. 1
Chapter 6:Using Demand and Supply: Taxation and Government InterventionPrepared by:Kevin Richter, Douglas CollegeCharlene Richter,British Columbia Institute of Technology
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Regulating Trade: Institutions, Government, and Trade Government provides the institutional
framework that facilitates trade.
Government regulates markets, preventing trades that are harmful and encouraging trades that are helpful.
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Roles of Government in a Market Provide a stable institutional framework. Promote effective and workable competition. Correct for externalities. Ensure economic stability and growth. Provide public goods. Adjust for undesired market results.
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Provide a Stable Set of Institutions and Rules Government can create a stable environment
and enforce contracts through its legal system.
Economic growth is difficult when government does not provide a stable environment.
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Promote Effective and Workable Competition Government promotes competition and
protect against monopolies.
Monopoly power is the ability of individuals or firms currently in business to prevent other individuals or firms from entering the same kind of business
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Promote Effective and Workable Competition Monopoly power gives existing firms or
individuals the power to raise prices.
Market participants often insist on open competition except when it comes to themselves.
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Promote Effective and Workable Competition Many players in the market insist on open
competition except when it comes to themselves: Farmers like competition but still want price
supports.
Lawyers and architects like competition but still want licensing to prevent others from entering the market.
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Correct for Externalities
An externality is the effect of a decision on a third party not taken into account by the decision maker.
Unless they are required to do so, parties to any exchange are unlikely to take into account any externality.
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Correct for Externalities
A positive externality is one in which society benefits even more than the two parties – an example is education.
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Correct for Externalities
A negative externality is one in which society as a whole benefits less than the two parties – an example is pollution.
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Correct for Externalities
When there are externalities, government has the potential role to change the rules so that the parties must take into account the effect of their actions on others.
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Correct for Externalities
Government may not effectively assume that role.
Government generally can only act within its borders.
Politics and vested interests may prevent government from acting.
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Ensure Economic Stability and Growth Most people agree that government should:
Prevent large fluctuations in economic activity.
Maintain a relatively constant price level.
Provide an economic environment conducive to economic growth.
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Ensure Economic Stability and Growth Most economists support these goals since
they involve macroeconomic externalities.
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Ensure Economic Stability and Growth Macroeconomic externalities are
externalities that affect the levels of unemployment, inflation, or growth in the economy as a whole.
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Provide Public Goods
Public goods are those goods whose consumption by one individual does not prevent their consumption by others – an example is a public park; another is national defense.
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Provide Public Goods
In contrast, a private good is one that, when consumed by one individual, cannot be consumed by other individuals – an example is an apple.
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Provide Public Goods
A free rider is a person who participates in something without having to pay for it.
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Provide Public Goods
Since most people would enjoy having public parks without having to pay for them, government requires that the public be taxed to pay for public parks, thereby reducing the free rider problem.
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Adjust for Undesired Market Results The government, through taxes and
expenditures, redistributes income among households.
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Adjust for Undesired Market Results In trying to be fair, which type of tax should
the government use?
This issue may be controversial.
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Adjust for Undesired Market Results A progressive tax is one whose rates
increase as a person's income increases. Canadian income tax is an example.
A regressive tax is one whose effect decreases as income rises.
Canadian sales tax is an example.
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Adjust for Undesired Market Results A proportional tax is one whose rates are
constant at all income levels, regardless of the taxpayer's total annual income.
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Adjust for Undesired Market Results Another controversial role for government
involves deciding what is best for people independently of their desires.
Should government prohibit demerit goods and activities?
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Adjust for Undesired Market Results Demerit goods and activities are those
considered to be bad for a person, although one may like them.
Addictive drugs are a demerit good; using addictive drugs is a demerit activity.
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Adjust for Undesired Market Results Merit goods and activities are things
believed to be good for a person, although one may not engage in them.
Motorcycle helmets are a merit good; using helmets while driving a motorcycle is a merit activity.
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Market Failures and Government Failures Market failures are reasons for government
intervention.
Market failures are situations where the market does not lead to a desired result.
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Market Failures and Government Failures Government intervention, however, need not
improve the outcome.
Government failures are situations where the government intervenes and makes the situation worse.
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Market Failures and Government Failures Real-world policy makers are left with the
choice of selecting that which is least bad – market failure or government failure.
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Producer and Consumer Surplus Consumer surplus – the value the
consumer gets from buying a product less its price.
It is the area underneath the demand curve and above the price an individual pays.
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Producer and Consumer Surplus Producer surplus – the value the producer
sells a product for less the cost of producing it.
It is the area above the supply curve but below the price the producer receives.
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Producer and Consumer Surplus The combination of consumer and producer
surplus is as large as it can be at market equilibrium.
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Producer and Consumer Surplus
Pric
e
Supply
Demand
Quantity
0
$10987654321
10987654321
Producer Surplus
Consumer Surplus
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Producer and Consumer Surplus The combined consumer and producer
surplus falls when price is above market equilibrium.
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Consumer and Producer Surplus
Pric
e
Supply
Demand
Quantity
0
$10987654321
10987654321
Producer Surplus
Consumer Surplus
Lost Surplus
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Taxation and Government
For government to operate, it must tax.
For the market to work, it needs government.
Tax rates depend on what goods and services government provides.
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How Much Should Government Tax? To answer this, we must know the costs and
benefits of taxation.
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Costs of Taxation
The costs of taxation include: The direct cost of the revenue paid to government The loss of consumer and producer surplus
caused by the tax The administrative costs of collecting the tax.
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Costs of Taxation
A tax paid by the supplier shifts the supply curve up by the amount of the tax.
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Costs of Taxation
When government raises taxes, there is a loss of consumer and producer surplus that is not gained by government.
This is known as deadweight loss.
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Costs of Taxation
Graphically the deadweight loss is shown in a supply-demand diagram as the welfare loss triangle.
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Costs of Taxation
The welfare loss triangle – a geometric representation of the welfare loss in terms of misallocated resources caused by a deviation from a supply-demand equilibrium.
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Costs of Taxation
S1
P1–t
Quantity
Price
P0
Q0
P1
Q1
Producer surplus
S0
Demand
Consumer surplus
Deadweight loss
tax
A
B C
D E
F
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Costs of Taxation
The other costs of taxation are the administrative costs of compliance.
Resources are used by the government to collect the tax and by citizens and businesses to comply with it.
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Benefits of Taxation
The benefits of taxation are the goods and services that government provides.
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Benefits of Taxation
Some of these benefits are the part of the basic institutional structure of a market economy that allows it to function efficiently.
The basic legal system is an example.
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Benefits of Taxation
Other goods have the qualities of a public good – fire and police services are examples.
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Benefits of Taxation
Some benefits are provided for reasons of equity or because they provide positive externalities. For example, education and healthcare.
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Benefits of Taxation
Measuring the benefits of government-supplied goods is difficult because they are not provided in a market setting.
Because they are not provided in a market setting, they are often provided at a zero price.
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Two Principles of Taxation
The government follows two general principles of taxation:
The benefit principle.
The ability-to-pay principle.
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Benefit Principle
The benefit principle states that the individuals who receive the benefit of the good or service should pay the cost (opportunity cost) of the resources used to produce the good.
Examples are gasoline taxes and airport taxes, both paid by travelers.
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Ability-to-Pay Principle
The ability-to-pay principle –individuals who are most able to bear the burden of the tax should pay the tax.
The best example of this is a progressive tax, such as the Canadian income tax.
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Applying the Principles of Taxation
The principles of taxation are difficult to apply.
The two principles often conflict.
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Applying the Principles of Taxation The elasticity concept helps us to understand
the tradeoffs.
The more broadly the good or service is defined, the more inelastic its demand.
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Applying the Principles of Taxation
In the language of consumer and producer surplus, if the government seeks to minimize the welfare loss, it should tax goods with inelastic supplies and demands.
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Burden Depends on Relative Elasticity The person who physically pays the tax is
not necessarily the person who bears the burden of the tax.
The burden of the tax depends on relative elasticity.
The burden of the tax is rarely shared equally since elasticities are rarely equal.
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Burden Depends on Relative Elasticity The tax burden is greater if a person cannot
easily change their behaviour.
The more inelastic one’s supply or demand, the larger the tax burden one will bear.
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Burden Depends on Relative Elasticity If demand is more inelastic than supply,
consumers will pay the higher share.
If supply is more inelastic than demand, suppliers will pay the higher share.
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Who Bears the Burden of a Tax?
590
Pric
e of
luxu
ry b
oats $70,000
60,000
50,000
40,000
30,000
20,000
10,000
Quantity of luxury boats 600200 400
S1
S0
Demand is inelastic.
Demand
taxConsumer pays
Supplier pays
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Who Pays Versus Who Bears the Burden of a Tax The burden of a tax is independent of who
physically pays the tax.
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Who Bears the Burden of a Tax? Tax levied on the consumer:
Pric
e
$7
6
5
4
3
2
1
Quantity6020 40
D0
S0
tax
Consumer pays
Supplier pays
D1
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Tax Incidence and Current Policy Debates The analysis of tax incidence is helpful when
discussing current policy debates.
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Employment Insurance Premiums Both employer and employee contribute to
the Employment Insurance.
The burden falls mainly on employees because, on average, labour supply is less elastic than labour demand.
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Burden of the Employment Insurance Premium
Wage
LabourL1
w0
wL
S
D0
wF
L2
t
Firms’ share
Workers’ share
D1= D0- t
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Price Ceilings
A price ceiling is a government-set maximum price which the market price cannot exceed.
Generally, the price ceiling is set below market equilibrium price.
It is an implicit tax on producers and an implicit subsidy to consumers.
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Price Ceilings
Price ceilings cause a loss in producer and consumer surpluses that is identical to the welfare loss from taxation.
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Effect of Price Ceiling
P0
Q0 Quantity
Price
Q1
Supply
DemandProducer surplus
Consumer surplus
Welfare loss
P1Price ceiling
Transferred to consumers
Excess demand
A
B
D
F
CE
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Price Floors
A price floor is a government-set minimum price.
Price floors transfer surplus from consumers to producers.
They can be seen as a tax on consumers and a subsidy to producers.
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Effect of Price Floor
Q1
Supply
DemandProducer surplus
Consumer surplus
Welfare loss
Transferred to producers
Quantity
Price
Excess supply
P2Price Floor
P0
Q0
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Taxes Versus Price Controls
The effects of taxation and price controls are similar.
Both taxes and price controls create deadweight losses.
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Taxes Versus Price Controls
However, price ceilings create shortages and taxes do not.
Shortages may create black markets.
Alternative methods of allocation develop because there is an imbalance between quantity demanded and quantity supplied.
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Rent Seeking, Politics, and Elasticities Price controls reduce total producer and
consumer surpluses.
Governments institute them because people care more about their own surplus than they do about total surplus.
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Rent Seeking, Politics, and Elasticities Individuals lobby government to institute
policies that increase their own surplus.
Others have the incentive to spend money to counteract that lobbying.
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Rent Seeking, Politics, and Elasticities If consumers hold the balance of political
power, there will be strong pressures to create price ceilings.
If suppliers hold the political power, there will be strong pressures to create price floors.
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Rent Seeking, Politics, and Elasticities Rent seeking – activities designed to
transfer surplus from one group to another.
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Rent Seeking, Politics, and Elasticities Public choice economists integrate
economic analysis of politics with their analysis of the economy.
They argue that often the taxes and the benefits of government programs offset each other and do not help society significantly.
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Inelastic Demand and Incentives to Restrict Supply When demand is inelastic, producers have
incentives to lobby the government to restrict supply.
Farming is a good example.
Advances in productivity increase supply but they result in lower prices.
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Inelastic Demand and Incentives to Restrict Supply
Since food has few substitutes, its demand is inelastic.
Inelastic demand means that prices fall faster than a rise in quantity sold.
Revenues fall, and farmers are worse off.
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Inelastic Demand and Incentives to Restrict Supply
Because of the increase in supply, and inelastic demand, farmers are losing revenue.
There is an enormous incentive for farmers to encourage government to restrict supply or create a price floor.
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Inelastic Demand and Incentives to Restrict Supply
S2
P1
Q1
P2
Q2
Demand
S1
Quantity
Price
Total Revenue
Revenue gained
Revenue lostA
B
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Inelastic Supplies and Incentives to Restrict Prices
Consumers are also rent seekers.
When supply is inelastic, consumers have incentives to restrict prices.
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Inelastic Supplies and Incentives to Restrict Prices When supply is inelastic and demand goes
up, prices jump causing consumers to lobby for price controls.
Rent control is an example.
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Long-Run Problems of Price Controls
In the long run, supply and demand tend to be much more elastic than in the short run.
Therefore, price controls will cause large shortages or surpluses in the long run.
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Long-Run Problems of Price Controls In the short run there will be small effects
from the price controls.
There will be huge effects in the long run.
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Long-Run Problems of Price Controls In the face of price controls, potential new
competitors hate to enter the market thereby strangling supply.
Vacancy rates drop as potential new renters scramble to find affordable housing in a shrinking market.
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Long-Run and Short-Run Effects of Price Controls
P0
Q0
P1
Q1
P2
Q2 Q3
Short run supply
D0
Quantity
Price
Long run supply
D1
Price ceiling
Shortage